Class 9 & 10 Real Estate

Disincentives for selling: What is recapture?

one of the major disincentives for selling your asset is the recapture of taxes on the deprecation you have already taken

• Purchase $1,000,000

• Depreciation $300,000

• Sale $1,200,000

  • Taxed on appreciation ($200,000) + Depreciation Exp ($300,000) = $500,000

  • depreciation recapture taxed at a 25% rate

Disincentives for selling: Refinancing

you can recover your value through refinancing, a non-taxable event and a far less expensive transaction.

• your $1.2m sale would require you to pay 25% on $300,000 of depreciation and 20% on your $200,000 capital gains, which is $115,000.00 in taxes

• a refinance will allow you to harvest a cash windfall without the tax consequence

Financial Leverage

benefits that may result for an investor who borrows money at a rate of interest lower than the expected rate of return on total funds invested in the property. It has a multiplicative effect on our equity investment

Positive vs. Negative leverage

debt can also amplify your losses - if your interest rate were to exceed your unleveraged Before-Tax IRR, we call that negative leverage

when it comes to forecasting the outcome of your investment, you must…

take a pessimistic, baseline, and optimistic view - including assigning probabilities

What are the ways that credit underwriters take into account when developing loans?

• Market Studies and appraisals

• Borrowers Financials

• Loan to Value Ratios

• Debt Service Coverage Ratio

• Other Loan terms/Covenants

Market Studies & Appraisals

• will require that the application for a loan is accompanied by a market study (including analysis of economic based and prospective employment grwoth for a region)

• validating assumptions as to the profitability of the asset investment (sometimes sufficient market trends are exhibited in the appraisal so as not to require a separate market study)

Borrower Financials

• lender will consider the borrower’s ability to pay its debts should income from the property be insufficient to

• includes schedule of real estate owned along with a personal financial statement that outlines your total net worth - personal assets against personal liabilities

• they want a personal track-record of successes and your personal financial condition is a strong indicator of your ability to perform under the terms of the loan

Loan-to-Value Ratios

• lenders do not typically loan past 75-to-80% of a property’s value. The reason being is that a lender wants to provide a cushion against foreclosure.

• Top-line value of the property would have to decline by 20-25% before the lender was unable to recapture the full balance of its loaned funds

Debt Service Coverage Ratio

• measure of NOI over Debt service to understand by what multiple of income the borrower is able to pay its debt

• lender will force certain underwriting perimeters into the borrower’s assumptions - vacancy rate, reserve for replacement deposits, etc. to allow for a little extra cushion

• in today’s market, it is aorund 1.15-1.25 which is anotehr way of saying that operating income could decline by 15-25% before mortgage payment was in jeopardy

Other Loan Terms/Covenants

• provisions that can be expected to be in any loan, called loan convenants

  • lender approval rights for any new major/commercial leases

  • lender approval to modify existing leases

  • lender approval for additional construction or modification to their mortgaged property

  • lender’s rights to conduct annual (periodic) site inspections

  • borrower’s obligation to supply periodic financial statements

  • borrower’s obligation to supply property appraisals every few years

  • borrower’s obligation to notify lender of any lawsuits

  • borrower’s obligation to notify lender of any major capital expenditures

The objectives of loan covenants (what do they serve)

• to ensure no material deterioration in the value/physical condition of the property (the mortgage security)

• to ensure no material deterioration in the income-producing ability of the property

Failure to meet these convenants are ground by the lender to declare that the borrower is in default of the mortgage terms, which could lead to potential foreclosure

Risk Analysis from Ch. 13 of Brueggeman text

idea of chapter: because different assets present different types of risks, you can not always compare their IRRS or NPVs to make an appropriate investment decision (risk depends on how you feel about it and what is your investment style)

Land Valuation: what can we do to valuate the propety?

• Sales comparison approach: comparing metrics of other vacant land sales and settling on an appropriate sales price

• allocation/extraction method: starts with the sale of “improved” properties and seeks to back into a land value based on a historically normative ratio or deduction of depreciated costs from other improved properties

Income capitalization approach

• used for sites where there is the potential to develop income-producing properties - tends to be driven by the “highest and best” use concept we have discussed in class. Most common in dense urban markets where land values are driven by redevelopment potential rather than comparable sales

Sale vs refinance technical points

• when you refinance, you are replacing one loan with another - perhaps for a higher amount. You are not selling or otherwise disposing of the property

• Your basis in the property continues to be: original cost + captial improvements - accumulated depreciation

why harvest (sell)?

• most importantly: in the real estate game, you often need to free up capital to make your next deal possible

• you may believe that the market is peaking and deciding not to sell may “trap” you in an asset that ultimately retreats in value

• structure: VCs often structure details on the assumption of a near-term “out” so if you are a syndicated firm, there may be a time horizon that you gave to your investors to unwind the investment

• the opportunity to participate in a value-adding change of use

Generational Planning

• real estate firms have very often been family-owned firms; this is in part because older generations can sell their younger generation limited partnership interests at a discount, can make loans to them, or can transfer properties at a price that allow the younger generation to take advantage of future growth in value

Gifting

• this is an important way to transfer assets to the next generation and there are few contexts in which generational gifting is more advantageous than in real estate

• no spot market

basic motivations for investing in real estate

• rate of return (investors anticipate that market demand for space in the property will be sufficient to produce net income after collecting rents and paying operating expenses

• price appreciation (investors anticipate selling properties after holding them for some period of time; and particularly in an inflationary environment, prices increase, which contribute to investor’s returns

• debt amortization

• diversification

• tax benefits

What are cyclical investments?

real estate is cyclical in nature;